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Stop Loss: A Good Sign You're Lost & Should Stop

August 22, 2012 | About:
The Science of Hitting

The Science of Hitting

236 followers
It’s not too difficult to find investment strategies that are inherently flawed; two of my personal favorites are beta as a measure of risk and stop-loss orders. I’ve written about beta in the past, so I’ll focus this article on the stop-loss order. In my mind, it doesn’t get much more idiotic than this: Someone buys a business at “X” and immediately determines that if the investment becomes more attractive (meaning they are able to buy more at a lower cost, say 99% of “X”), they will sell it immediately. I would love to see the shareholder response if a company drafted the following press release:

“ABC Corporation today announced that its Board of Directors has received and unanimously rejected an unsolicited proposal from XYZ to enter into a transaction under which XYZ would acquire ABC for $20 per share in cash. ABC’s board reviewed the offer with the assistance of its independent financial and legal advisers and concluded that the proposal is grossly inadequate; with that being said, if other market participants indicate interest in the company at a price below $20 per share, our board would be more than happy to consider this much improved offer.”

Warren Buffett wrote about a form of the stop-loss order that was partially responsible for the crash of 1987:

“We have ‘professional’ investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.

An extreme example of what their attitude leads to is 'portfolio insurance,' a money-management strategy that many leading investment advisers embraced in 1986-1987. This strategy — which is simply an exotically labeled version of the small speculator's stop-loss order — dictates that ever-increasing portions of a stock portfolio, or their index-future equivalents, be sold as prices decline. The strategy says nothing else matters: A downtick of a given magnitude automatically produces a huge sell order. According to the Brady Report, $60 billion to $90 billion of equities were poised on this hair trigger in mid-October of 1987.

If you've thought that investment advisers were hired to invest, you may be bewildered by this technique. After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have brought on the previous day?

Moves like that, however, are what portfolio insurance tells a pension fund or university to make when it owns a portion of enterprises such as Ford or General Electric. The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a 'logical' corollary, the approach commands the institutions to repurchase these companies — I'm not making this up — once their prices have rebounded significantly. Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in aberrational fashion?”

Many market participants suffer from two critical shortfalls: They don’t have the slightest clue on how to conservatively value a business, and they don’t think like owners. As a result, they cannot take advantage of opportunity (lower prices), and instead see it as a sign of defeat.

Unfortunately, volatility is a reality: Even the safest companies (and some of the best investments of the past half-century) will periodically have their face pushed in the mud. A fantastic example of this is Berkshire Hathaway (BRK.A)(BRK.B): Since 1965, book value has increased at a compounded annual rate of 19.8% (book value went from $19 to $99,860 per share), and has only declined on a per share basis twice in that entire period, both times by single digits; that is a truly astounding record on the back of persistent advances higher.

With that information, one would assume that Berkshire has been relatively stable in comparison to most publicly traded companies, and that a stop-loss of 50% (many would argue that this is adequate room for volatility and that any decline of this magnitude would signal serious problems) would likely never be triggered; would it have held up over the past 47 years? Our answer comes from an interview with Charlie Munger that took place in during October 2009:

Question: “How worried are you by the declines in the share price of Berkshire Hathaway?”

Charlie: “Zero. This is the third time that Warren and I have seen our holdings in Berkshire go down top tick to bottom tick by 50%. I think it’s in the nature of long term shareholding, of the normal vicissitudes in worldly outcomes and in markets, that the long term holder has his quoted value of the stock go down by say 50%. I think you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you are going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

I revert back to what I wrote above: Without the mindset of an owner and the ability to conservatively value the business in question (which means staying within your circle of competence), it will be painfully difficult to stick with companies that are experiencing periods of poor share performance. My simple test is the following: When you buy any stock, simply ask yourself, if the shares decline 25% in the next six months, am I a buyer? If you are feeling queasy as you contemplate this, that’s a good indication that you may be setting yourself up for disaster (if a company’s competitive position in an industry can materially change in 6 to 12 months, that’s a warning sign as well).

Many people don’t think about this until they are deep in the red; if you focus on the downside now rather than later (and find yourself not only prepared for it but hoping for it), you can avoid a regrettable situation that has caused many investors sleepless nights and mediocre results.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.3/5 (33 votes)

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Comments

marcolanaro
Marcolanaro - 2 years ago
Excellent article!!

ecotycoon
Ecotycoon premium member - 2 years ago
Really good article once again.

Having the chance of owning share of a great business that is going down, is like a opportunity to add more for cheaper with less risk in a business you already know. I just don't get the idea why stop loss is so popular, make no sense, I think people tend to invest too much, while not keeping enough in short term security or cash and can't afford the technique of averaging down or mabee they don't analyse enough and are not confident in their choice and knowledge.

It could be a good question to a portfolio manager if they pratice this stop loss technique to avoid risk, better run as fast as possible from is office ... haha .... :)

Rule #1 Never loose money

Rule #2 Never forget rule #1.

The Science of Hitting
The Science of Hitting premium member - 2 years ago
Marcolanaro,

Thanks!

Ecotycoon,

If the manager says yes, start running...
bertens
Bertens - 2 years ago
some of the smartest investors in the world like Paul Tudor Jones use stop loss orders. Therefore stop loss are stupid? Come on. This argument does not make too much sense. Even though you analysed everything you still could have overlooked something or your analyses was simply wrong. I would argue that using stop loss orders is one of the smartest decision you could make to protect your capital.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Bertens,

What doesn't make sense about it? Certainly you may be wrong about an invesmtment - but you judge that based on fundamentals, not stock price volatility (and size accordingly based on margin of safety, ability to forecast change in the industry, etc). If you liked a business at $20, why would you automatically sell at $18? Wouldn't you want to buy more if you were thinking like an owner?

If you think the market knows more than you about a security, then why even bother initiating a position in the first place? That is not investing - that is speculation. Berkshire has seen their stock contract 50% plus on three seperate occasions - even though intrinsic value likely changed by just a fraction of that amount; a stop loss would have caused you to abandon ship at what has proven to be the best times to buy more.

There is no logical justification for such a strategy - and you are fooling yourself if you think that selling as companies become more attractive is a smart way to protect capital.

Seanickson
Seanickson - 2 years ago
Jones is a trader, not an investor. He is a very successful one. However, for those of us who own shares Of businesses in whice we have confidence in their lorn term success, stop losses are unnecessary. Great article
Adib Motiwala
Adib Motiwala - 2 years ago
Rather than automatic stop loss, i use a certain drop in share price to re-check the thesis and see if i have conviction to buy more or just hold. I rarely have sold at the worst times ( on a 20% drop in share price for example). I would say this - it is impossible to know everything about a company. You have to look at what are the key factors of the thesis and focus on that. So, i do not agree with that one line you said " If you think market knows more about you...."...

Stop loss may not be right for everyone. However, blindly averaging down (and multiple times at that) is also a potential recipe for disaster (RIMM, RSH, ATPG etc)

The Science of Hitting
The Science of Hitting premium member - 2 years ago
Adib,

I agree with that - but rechecking your thesis and then making a decision is different than automatically hitting the sell button. Naturally, you will never know everything about a company, and even if you did you still can't predict the future with 100% certainty; my point is that if you enter an investment without an edge (you think you see an undervalued security that by definition is not being recognized by the market) then you are speculating, not investing.

On your last point, I agree, and that's the point - when buying or selling, don't act blindly. Thanks for the comment!
Cogitator99
Cogitator99 - 2 years ago
Good article. As noted, the key is not to do anything blindly. Haha.
bertens
Bertens - 2 years ago
you sell because you want to protect capital it is as simple as that. Especially if your selling does not effect the stock price, i.e. you are a small trader/investor. You can always reenter later. When a trader becomes and investor or vice versa is an argument of definition if the dichotmy is useful at all is subject to debate. I just think it is false ideology of value investors not to operate with stop losses. George Soros uses stop losses as well. You can label him a trader but Warren Buffet can be labeled a trader as well, I forgot which book made that thesis, especially in hia early investing career. My thesis is that most investors are well advised to operate with stop losses. If you are are a second Warren than maybe you are exempt.By not using stop losses you are sucked into the false ideology by die hard value investors. For most investors/traders limiting your losses is well advised in my opinion, especially if you want to protect capital and is'nt that rule number one and two???
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Bertens,

The case for selling something at a lower price than what you willingly bought it for cannot be justified, unless you reassess your original thesis and conclude that it was flawed or that the fundamentals have changed. As noted above, both of these things can happen; my contention is that people who blindly sell simply because the price has fallen (the purpose of a stop-loss order) are not investing.

As you note, limiting your losses is fundamentally important - and you do that before initiating a position only after thoroughly analyzing the company and the industry and conservatively estimating intrinsic value (from which you must command a sizable margin of safety).
bertens
Bertens - 2 years ago
The Science,

most people cannot thoroughly analyze the company and estimate intrinsic value. And even if they could there could be another 2008/2009. Remember you can always buy back at a lower price. From readings of the greatest investors/traders I found out that most actually use stop losses. I just use a strategy that works. I posit that most investors will profit handsomely from limiting your losses. Soros for instance invests before analyse Dan Loeb does sometime the same thing. Do not buy into all of the dogmas of value investing theory you might have more money at the end. Use different philosophies. I know it is hard to change gods, but that is not required just be critical and little less undogmatic.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Bertens,

It has nothing to do with dogma or gods; it's about acting rationally, and stop loss orders are an irrational practice for people who think like business owners (I'm not sure who you consider the greatest investors, but I've never heard the one's I consider to be the best advocate such a strategy).
bertens
Bertens - 2 years ago
The Science,

its all about gods and dogmas. Just use different mental models, that is Munger I believe. A reading tip which is not that secret: Read all the Schwager Market Wizards Books, at least 4-5 times. Well if it works for you more power to you. I use a combination of value investing, technical analsis, seasonality aso. At first I bought into everything value investing told me and I myself became dogmatic. When I started incorporating different ideas, mental models, I just became more successful. I believe most people will benefit from hearing different ideas. Buffet ideas can be wrong. His gold analogy for instance does not make much sense, even Einhorn discredited him and rightly so. So open up to different worlds, ideas and if you will so gods and dogmas :-).
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Bertens,

I'm all about different mental models, as long as they make sense; stop loss orders based upon nothing other than market volatility are illogical, and I will not adopt a strategy that makes the market my guide.
bertens
Bertens - 2 years ago
Science,

I posit that a lot of people will safe a lot of money by using stop loss orders. And limiting your risk can't be done be just analysing the company thoroughly.
yentrader7
Yentrader7 - 2 years ago
I'm surprised no one mentions the Married Put here,

great strategy even if the stock gaps down on you.

saved my butt many times with small loss/

good trades to all

Yen Trader
bertens
Bertens - 2 years ago
Yentrader 7,

thats actually great for bankruptcy situations if you can find cheap puts or puts at all.
LwC
LwC - 2 years ago
Bertens,

In theory I agree with you FWIW, that different investors, traders, speculators, etc. will use different tools, assumptions, methodologies, etc. according to their own POV's, temperaments, goals, availability of capital, risk tolerance, time frame, etc. IMO it's that diversity of opinions that makes a market. Investor A thinks a company's shares are priced too high for whatever reason and sells the shares to Investor B who's opinion must be contrary to Investor A, or else Investor B wouldn't buy those shares at that price. Some investors are comfortable using stop loss orders, and others aren't, for whatever reasons. So in that I tend to agree with you.

However, when you write this:

"Buffet ideas can be wrong. His gold analogy for instance does not make much sense, even Einhorn discredited him and rightly so."

…I can (and do) agree that Buffett ideas can be wrong; after all Buffett himself is not shy about many of his mistakes. But IMO contrary to your assertion his gold analogy does make sense. That doesn't mean that he is right "absolutely"; only IMO that he is right for himself and for those like myself who think it makes sense. IMO your inability to see the sense in his comments about gold price speculation vs. alternative investments says more about you and your POV than about the "sense" of Buffett's comments.

However when you further assert that Einhorn "discredited him and rightly so," well IMO that's just as doctrinaire as your accusations against others who have disagreed with you in this discussion. Simply put, I read Einhorn's critique of Buffett's comments about gold price speculation and I just don't agree with it. IMO he didn't manage to discredit Buffett, only to clearly state that his opinion differs from Buffett's, and why. Einhorn may be right for those who like to speculate, but not necessarily for those of us who don't like to speculate. (I acknowledge that my use of the phrase "gold price speculation" reveals my investment style bias. I try to avoid price "speculation" because IMO I don't have the temperament, risk tolerance, or tools to successfully "speculate")

Einhorn apparently does successfully "speculate" and good for him. He presented his thesis for gold price speculation and some of us accept it, and others reject it.

Again, IMO it's those different opinions interacting in the markets that makes it possible to have a market. At the end of the day IMO Buffett is right with his gold analogy because he finds that he can invest and successfully meet his investment goals without speculating in the price of gold. And Einhorn is also right because he finds that he can invest and successfully meet his investment goals by speculating on the price of gold.

Good luck.

"The early bird gets the worm, but the second mouse gets the cheese."...unknown source

bertens
Bertens - 2 years ago
LWC,

Einhorns argument is more convincing to me. Just look at the last decade price appreciation Berkshire against gold, what was the better deal?
Cornelius Chan
Cornelius Chan - 2 years ago
The way I see things is... if you are speculating or trading, stop loss orders work because you are basing the strategy more on price action. If you are investing, stop loss orders do not work/are irrelevant because you want to double down on the undervalued shares. The investor loves to see share price fall vs. the speculator who attempts to short stocks. The investor seeks to buy shares at low and lower prices to increase the upside.

Please separate these different ways of stock market activity and there is no more argument on this topic.
bertens
Bertens - 2 years ago
I just got an email from daily wealth. A mathematican proved somehow that stop loss oders, trailing stop loss orders is a strategy that works for private investors. I have not seen the original mathematics if somebody has them please share. For the rare superinvestors a la Buffet that might not be the case. For most people it will make great sense.
Bill.Smith
Bill.Smith premium member - 2 years ago
Science: excellent, good food for thought for folks.

Bertens: I agree with only one thing you mentioned: "most people cannot thoroughly analyze the company and estimate intrinsic value." That's why there are index funds... the know-something investor vs. the know-nothing investor, as Buffett points out. Earlier you suggested Science do some reading on the Market Wizards books. For you I suggest, maybe 4 or 5 times, The Intelligent Investor, Chap. 8, 'The Investor and Market Fluctuations.' Good luck.

LwC
LwC - 2 years ago
Bertens, you wrote: "Just look at the last decade price appreciation Berkshire against gold, what was the better deal?"

Look at the last six months. Or look at the last thirty years. How about the last three trading days? Pick your time frame.

AFAIK, one dollar invested in BRK in 1982 would be worth about $125 now. A dollar invested in gold in 1982 would be worth a little less than $5.00 now. Well, 20/20 hindsight and all that; doesn't really do us much good going forward does it?

Interestingly you tout gold's performance over the last ten years. Well ten years ago gold sold at a lower price than it did twenty years earlier. Meanwhile BRK multiplied by about 70 times during that same twenty year period.

Maybe I misunderstand Buffett's analogy about gold. But AFAIK all he was saying was what the BRK share price over the last thirty years shows, as compared to gold: that through numerous recessions, and various cycles of interest rate and inflation fluctuations over several business cycles, owning a good business has been a better investment.

No question gold has been a hot play recently. Will gold be priced at 125X thirty years from now and BRK at 5X thirty years from now, the opposite as has occurred over the last thirty years? I don't know, and even though Einhorn is a lot smarter and experienced than me I'm still willing to bet that he doesn't know either.

joe_litehorse
Joe_litehorse - 2 years ago
Very good article. However, a "limit sell order" can be used for locking in gains. Very useful in these times of extreme volatility caused by (your referenced) stop loss investment managers and short sellers. Further, I no longer transact during earnings season, and always transact using limit orders with the limit sells priced just below the current trade price ( who knows, the price may go up some more.

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